Western tax and Islamic finance
Issue 16 of Islamic banking and finance. Great resource to study to understand the marketing and promotion of Islamic Finance. It should be noted that this site promotes Islamic banking, therefore the “sunny side” of the coin is being presented, without full disclosure of shariah laws and their implications. This is why the incidious nature of this type of banking is something we have to be concerned about, and why this blog was created. There is no such thing as “interest free” just like there is no such thing as a “free lunch”.
comments by Allyson Rowen Taylor
A company wishes to purchase a machine, to be delivered immediately, with a manufacturer’s price of $1,000. The machine will be useable for five years. If purchased with conventional finance, the customer will pay for this machine immediately, financed by a bank loan of $1,000, carrying simple interest at 5% per year, with all of the interest to be paid in full when the loan is repaid after two years.
If acquired with Islamic finance, the bank will purchase the machine from the manufacturer for $1,000 and resell it to the customer for $1,100 with immediate delivery, permitting the customer to only pay the bank the price after two years. In both scenarios, the customer has the same cash-flows, obtaining the machine for immediate use and paying out $1,100 after two years.
Tax law varies from country to country, and is usually complex. Assume a hypothetical tax system under which capital equipment, such as this machine, can be amortised for tax purposes, on a straight line basis, commencing only after the machine has been paid for. Tax relief for finance costs is given on an accruals basis over the life of the debt. The hypothetical tax system, developed in an environment of conventional finance, has no problems computing the tax deductions the customer is entitled to. The key principles underlying the tax treatment are that the customer has paid for the machine on delivery (even though financed by a bank loan) so the tax amortisation starts immediately, and the customer will be paying $100 interest to the bank, spread evenly over the two-year life of the loan. When the customer acquires the machine under Islamic finance, it is not paid for until after two years, and the legal contracts record no cost of finance. Instead there is the purchase of a machine costing $1,100, which is only paid for two years after delivery. There are two fundamentally different ways for the hypothetical tax system under consideration to look at this Islamic finance transaction.